## Crazy Spot Curves – Orderly Forwards

This is an interesting chart I think. It shows the spot CPI swap curve (that is, expected 1y inflation, expected 2y compounded inflation, expected 3y compounded inflation), which is very, very steep at the moment because of the plunge in oil. It also shows the CPI swap curve one year forward (that is, expected inflation for 1y, starting in 1y; expected inflation for 2y, starting in 1y; expected inflation for 3y, starting in 1y – in other words, what the spot curve is expected to look like one year from today). The x-axis is the number of years from now.

The spot curve is so steep, it is hard to tell much about the forward curve so here is the forward curve by itself.

Basically, after this oil crash passes through the system, the market thinks inflation will be exactly at 2% (a bit lower than the Fed’s target, adjusting for the difference between CPI and PCE, but still amazingly flat) for 6-7 years, and then rise to the heady level of 2.10-2.15% basically forever.

That demonstrates an amazing confidence in the Fed’s power. Since inflation tails are longest to the high side, this is equivalent to pricing either no chance of an inflation tail, or that the Fed will consistently miss on the low side by just about exactly the same amount, and that amount happens to be equal to the value of the tail more or less.

But what is really interesting to me is simply how the wild spot curve translates so cleanly to the forward curve, at the moment.

I’ve never thought about this as a retail investor, but with a bit of leverage and the access to that market isn’t there some money to be made capturing that spread?

No – the second curve is just calculated from the first curve. So if you buy 2y inflation, in 1y you expect to have a swap at 2% remaining inflation. In order to win, you need to have inflation in 1y be above that. In fact more investors probably bet the other way, that the forwards won’t rebound by as much.

Since these curves are separated in time by 1y, in other words, there is no way to trade them against each other per se. Make sense?